Market Stays Vigilant Despite Recent Calm

November 21, 2019

Source: Bloomberg Source: Bloomberg

For the two week period starting 11/4/19 to 11/15/19, the total realized volatility for the S&P 500 Index was below 5% — the lowest since the summer of 2018. Several macroeconomic and market factors have contributed to the low volatility.  One contributing factor is the unlikelihood the Federal Reserve (Fed) will cut or raise interest rates in the near future. Another factor is trade war tension has subsided as a phase-one deal is expected soon. These factors coupled with the 3Q19 earnings season, during which S&P 500 stocks moved in idiosyncratic ways, has resulted in a correlation breakdown.

During the same time frame, short-term implied volatility declined. On 11/15/19, the implied volatility of one-month S&P 500 at-the-money (ATM) options was sub-10%, a touch higher than its lowest level in 2019. Implied volatility is a financial market risk barometer reflected through the lens of options and is positively correlated with option price. It surges in financial market turmoil because option writers demand higher option premiums for the risks taken. In December 2018, the one-month S&P 500 ATM implied volatility rose to over 30%.

Option maturities can spread from as short as one day to years. Beyond two years, liquidity is thin and it is important to note that implied volatilities vary for different maturities. More often than not, the longer the maturity, the higher the implied volatility. A similar circumstance often occurs in bond yields. The difference between longer-tenor implied volatilities and shorter-tenor implied volatilities is known as term premium. The premium compensates option writers for holding on to risks into the more distant future, which is less predictable than the immediate future.

It is intuitive to assume that the one-year implied volatility would move with the one-month implied volatility. However, the one-year implied volatility has recently veered off course. Consequently, as shown in the chart of the week, the term premium between the S&P 500 one-year ATM implied volatility and one-month ATM implied volatility is at a one-year high.

What information does the implied volatility term structure convey? From my perspective, the markets are primarily concerned with the development of two topics. Most saliently, the markets are focused on the 2020 U.S. presidential election. The wide range of policies proposed by the Democratic candidates and the volatile polls make the impact on financial markets extremely difficult to assess. Another uncertainty stems from U.S. trade policies. Although a phase-one deal with China seems imminent, it is apparently quite shallow and will leave the thornier issues to further negotiations down the road. Few anticipate a smooth ride.

Key Takeaway

The equity market has been calm for the last few weeks. Although short-term implied volatility has fallen with realized volatility, the long-term implied volatility is holding strong, leading to the highest implied volatility term premium in the past year. Option writers are well aware of the risks and unwilling to lower premiums. I favor tactical trading strategies to help take advantage of the steep implied volatility term structure. The risk/reward for such strategies looks quite favorable in the near term.


Tags: Volatility | options | Markets | term premium | implied volatility

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